Every investor is seeking growth, income, or a combination of the two. Indeed, the reason people buy stock is based on its company’s current or future earnings (income). Most investors past age 65 are looking only for reliable current income with growth as a distant secondary concern. One way to summarize investing is that eventually, everyone wants income.
The advisor’s job is to make sure that all sources of income are conservative and consistent. Investors typically think of U.S. Treasuries and bank CDs, but there are usually better alternatives. These traditional alternatives include fixed-rate annuities, TIPS, iBonds, and municipal bonds. Non-traditional sources include emerging markets bond funds, high-yield bond funds, bank loan funds, short-term bond funds, systematic withdrawal plans, and covered call writing. Each of these non-traditional opportunities has its pluses and minuses.
There are also income-oriented investments that should be avoided: non-publicly-traded REITs, most EIAs, and a large number of royalty trusts. Non-publicly REITs have been the subject of a FINRA Investor Alert, which points out not only a lack of liquidity but often huge disparities between the selling (or buying) price per share versus the actual value of the underlying assets on a per share basis. This disparity is often 25-50% or more. Since non-publicly traded REITs are less regulated, the advisor should expect overstated valuations and greater conflicts of interest with the issuer or its affiliates.
The problem with most equity-indexed annuities (EIAs) is that their overall return ends up being less than expected. EIAs are often hyped by the broker looking to make a large commission. For example, when the historical return of the S&P 500 is shown (since the majority of EIAs are credited interest based on the S&P), the performance is almost always showing total return figures. The fact is that no EIA bases its rate on any index that includes dividends. Historically, almost half the return from the S&P 500 has been from the reinvestment of dividends.
The proper way to describe the typical EIA is to tell the client that he should expect a return that is a little bit better than what CDs are yielding. Yes there is upside market potential, but EIA contract provisions greatly limit that upside. There have been periods when EIAs have outperformed the stock market, but this typically happens when interest rates are much higher than they are today (note: a low interest rate environment means the EIA issuer must spend more on STRIPS in order to protect principal and less on futures and options for the “growth” portion).
Royalty trusts certainly sound appealing and simple—revenue from leasing operations, natural gas, or oil. However, often omitted from the description is that unlike bonds, there is no return of principal at the end. Most royalty trusts are comprised of self-depleting assets. When there is no more oil or gas, payments stop. When there are interruptions in supply, income to the investors decreases. Most importantly, investors (and advisors) are willing to pay a modest to hefty premium for what appears to be high income (“appears” because the return of principal component is not usually factored in). This premium is sometimes 15-25% or more.
This means an investor is willing to invest $10 today in return for a cumulative return of $7.50 to $9.00, spread out over the next several years. Any kind of premium means your client is going into a terrible investment—consider opportunity cost and the effects of inflation. You can get a far higher return by going into a balanced fund and setting up a 10-15% annual SWP. True, after 10-15 years all of the client’s money will be gone, but the overall results will still be better than how some royalty trusts are structured.
What You Need To Know
It has often been said that more money has been lost from investors seeking too much income than from those investing for growth. All too often, the advisor is given a sales pitch by a product group that focuses on something modestly important while completely avoiding what should be major concerns (e.g., non-publicly traded REITs all emphasis stability of pricing and lack of correlation to other asset categories but rarely talk about real valuations or the gap between the offering price and the liquidating price).
The advisor needs to know what asset categories and what investment vehicles should be considered, as well as those that should almost always be avoided. The Institute of Business & Finance (IBF) offers a certification program that does just that. The six-part program costs $1,050 and includes updated materials, sample questions, and exam fees. The Certified Income Specialist
(CIS) designation is specifically designed for advisors who have older clients. The table below is a partial list of the topics covered by this IBF program.
Certified Income Specialist Topics [partial list]
- Investment Policy Statement